Sunday, December 15, 2013
Carney looks on the bright side of life

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

Mark Carney, having been exposed to the British economy for six months (though he also lived in London in the 1990s) has emerged more optimistic about both the short and the long-term. Normally the opposite happens.

The new Bank of England governor's optimism is in sharp contrast to his predecessor. Lord King had many estimable qualities but nobody would accuse him of having a sunny disposition when it came to the economy in recent years. Colleagues on the Bank's monetary policy committee (MPC) learned that it was hard to out-gloom the governor since the crisis.

His successor set out his optimistic stall in a speech a few days ago to the Economic Club in New York, though he has been building up to it. Citing positive economic news, including a drop in inflation from over 5% to 2.2% in the space of two years and job creation of 60,000 a month, he declared that "the cumulative run of economic surprises has dwarfed those of the other major advanced economies". The news, in other words, has exceeded expectations more in Britain than elsewhere.

The recovery, he said, reflected an easing back of extreme uncertainty, successful repairs to a damaged financial system and an improvement in household balance sheets.

More importantly, Carney robustly challenged the idea, sometimes known in the jargon as "secular stagnation", that growth has somehow come to an end in advanced economies and the best we can look forward to is a never-ending series of lost decades. That idea, perhaps unsurprisingly, originated in the Depression years and is usually attributed to Alvin Hansen, an American economist and follower of Keynes.

In Britain, much of the pessimism is now about productivity, but also investment. Growth, in the pessimists' view, can be pumped up by repeated injections of debt but has no underlying supply-side strength. So it will always be fragile and unbalanced.

That view does not reflect what appears to be a broad-based upturn now in the economy, with manufacturing, construction and services all growing strongly and, within that, business-to-business spending and production of capital goods (normally associated with higher investment) leading the way.

Nor, according to Carney, does it reflect the outlook for Britain. Though the near-record deficit on the current account (of the balance of payments) is troubling, it largely reflects economic weakness elsewhere in Europe.

And: “Although the current account position underscores the need for the recovery to shift over time towards investment and export growth, it would be unreasonable to expect that to have happened already. Recoveries are seldom led by investment.”

He also has an interesting take on productivity, which is that workers priced themselves into low-productivity jobs when demand in the economy was weak, but will move into higher-productivity work as growth strengthens. The productivity switch was not, in other words, suddenly turned off in 2008.

“Given the flexibility of its labour market, the continued openness of the economy and the credibility of macro policy, it is hard to think of any reason why there should have been a persistent deterioration in the rate of potential growth in Britain,” he said.

So, a glass “more than half full” view of the economy. Carney's most telling blow against the pessimists, perhaps, was that they have always been wrong before. “There is a long history of pessimism in economics, from Thomas Malthus through Alvin Hansen to Robert Gordon,” he said. “Such worries have proven misplaced in the past and scepticism is warranted now. Don’t forget that the US economy is more than 13 times larger than when Hansen first formulated his ideas.”

Should a central banker be optimistic? As a breed, are they not supposed to be constantly looking in the dark corners for the risks and dangers, a job they failed to do very well before the crisis?

The role of a central banker, according to former Federal Reserve chairman William McChesney Martin’s much-quoted dictum, is to take away the punchbowl just as the party is getting going. Carney instead is a genial mine-host, not only filling up the punchbowl but lining up the glasses along the bar.

Should they not now be starting to withdraw the exceptional monetary stimulus - near-zero interest rates and quantitative easing - which has helped drive the upturn? Andrew Sentance, a former member of the MPC, argues that this is precisely the moment to begin edging interest rates up.

Carney sees it differently. His policy of forward guidance - a pledge to keep Bank rate at the current 0.5% at least until the unemployment rate gets down to 7% - is in the best sense of the word a confidence trick. The trick is to boost confidence.
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His MPC colleague Martin Weale used a speech to point out that the direct economic effects of forward guidance, in comparison with what the markets were expecting to happen to interest rates, is probably very small.

Weale’s scepticism was justified. The Bank’s latest forecast assumed the mere announcement of forward guidance would have a significant impact on growth but these things take time, particularly as far as the public is concerned.

The Bank’s own NOP survey of inflation attitudes, just published, shows that 34% of people think rates will rise over the nexct 12 months. Mind you, 22% believe they have risen over the past 12 months.

So Carney’s optimism is genuine, but it is also a deliberate attempt to build on his forward guidance policy by making it more effective. If people are worried that a housing bubble is on the way and will mean higher interest rates, they need not be, because the Bank will use other means at its disposal, targeting the lenders with so-called macro-prudential tools, instead.

Similarly, if households and businesses are reluctant to take advantage of ultra-low rates because they fear growth will not last, he is assuring them that historical precedent suggests that it will.

If pessimism has negative effects - evident in very low levels of business and consumer confidence until recently - optimism can have positive consequences as it gains traction. The governor is happy to be a cheerleader for this process.

Is this is a risky strategy? There is always a danger that interest rates are too low for too long. The MPC, according to Carney, believes the “equilibrium real interest rate” is currently negative, in other words that it is appropriate for Bank rate to be below inflation.

That will change as the economic evidence improves. The sooner the governor’s confidence is reflected in a stronger and more durable recovery, and the risks of a setback become much lower, the sooner it will be appropriate to raise rates.

That will not be for some time but the interest-rate worriers should not begrudge Carney his optimism. In the end, he will be on their side.